where orders emerge

More on Fannie and Freddie and the crisis

In this recent post, I suggested that Wallison and Pinto were wrong in their relentless arguing that Fannie and Freddie caused the financial crisis because of government requirements that F and F buy loans made to low-income borrowers. For one, Wallison and Pinto ignore the role of the investment banks in generating subprime loans and bundling them into mortgage-backed securities. I also pointed out the possibility that Fannie and Freddie seemed to be a lot like the investment banks–maybe they bought up risky loans simply to make money:

One more point–the SEC suit doesn’t really fit the “government made Fannie and Freddie buy up lousy loans” story. The whole point of the suit is that these were secret behaviors by Fannie and Freddie. They were buying a lot of loans that were a lot like subprime–loans with high default risk. But were these to satisfy ever more demanding affordable housing requirements imposed by the government? Who knows? I suspect they were just trying to make money like the other players. They just stayed in too long.

William Black, in this lengthy essay, makes the same point but also provides some evidence rather than just speculating as I did. He takes down Wallison and Pinto as well as critiquing some of those such as Joe Nocera who have dismissed Wallison and Pinto entirely. Black’s essay is a must-read. He argues that it was the compensation structure at Fannie and Freddie (and at the investment banks) that encouraged large short-run gains even if they would eventually lead to devastating long-run losses. The only thing Black fails to explain is why those compensation packages were so opaque to outside investors who ultimately funded those decisions that blew up. As I wrote in that recent post:

To really explain the housing boom and bust followed by the financial crisis, you need an explanation of why Fannie and Freddie AND the investment banks were so reckless. The Pinto/Wallison explanation is that Fannie and Freddie were reckless because the government made them do it. The left’s explanation is that the investment banks were reckless because the govnernment let them do it. Both left and right ignore the role of the other part of the market. But more importantly, both the left and the right leave unexplained how the reckless risktakers–the GSE’s and the investment banks–were able to do it–how they all were able to borrow money at relatively low rates despite ridiculous levels of leverage. How were they able to borrow all that money at so low rates when leverage meant high risk for the lenders?

My answer is that they were all GSE’s, all government sponsored enterprises–Fannie and Freddie and Bear and Citi and Goldman and Lehman and on and on. They all had an implicit guarantee from the government that allowed them to borrow at low rates (often from each other), rates that were well below market because of the implicit guarantee. And they were able to borrow at low rates even though they were highly leveraged which made them vulnerable to defaulting on their debt. Despite that vulnerability, they were still able to borrow at low rates. When things fell apart, almost all the creditors, lenders, and bondholders got all their money back, 100 cents on the dollar. The only exception was Lehman. The rest were all taken care of despite funding really bad bets.

The right argues that the cause of the crisis was that the government made banks (Fannie and Freddie and CRA) buy bad loans. The left argues the government through deregulation let investment banks run amok. Each is partially correct.

My explanation is a little more complicated but it is also simpler in that it explains the behavior of the investment banks and Fannie and Freddie: past bailouts of large creditors increased the expectation of future bailouts. That in turn let all financial institutions borrow from large creditors at reduced rates and in enormous amounts relative to using their own money. Here is William Black’s recipe for how a lender can enhance short-run gains, artificially inflating profits for the institution, pocket a really big bonus, and let the costs come later (and fall on someone else):

Grow like crazy

By making (or buying) exceptionally bad loans at a premium yield, while

Employing extreme leverage, and

Providing grossly inadequate allowances for loan and lease losses

What is missing from Black’s story is how to employ extreme leverage in the current situation. Who is stupid enough to lend you money knowing how little money of yours is on the line and knowing that as a lender you only get a fixed return and do not share in the upside? The answer is that you don’t have to be stupid to do it if the government stands behind you. Then lending to reckless investors is smart not stupid.

In the case of the S&L crisis (which is where Black has enormous institutional knowledge–he worked for the FDIC), the lenders were depositors who didn’t have to worry about the quality of the institutions that held their money and offered attractive rates of interest–the FDIC would bail them out. In the crisis of 2008, the government stood behind the creditors of Fannie and Freddie and Bear Stearns and AIG and CitiBank and Bank of America.